The reason domestic currencies drop may baffle some newbie FOREX investors since many movements are rooted in what are called ‘expectations’. You see, currency movements move up or down (depreciate or appreciate) based on expectations and/or real announcements. Here is an article to help you track currency movements because predicting currency movements is a skill that can be learned to some degree.
Let’s use an example for the remainder of this article. On Monday May 7th, 2007, the US dollar dropped (depreciated) against other main currencies. The FED had yet to make any formal announcement, but some new economic numbers were revealed that provided an indication what future decisions may be.
Some investors saw how US economic numbers, in this case lower job creation values, could potentially impact a FED decision to drop interest rates. The decision would actually be made in the future, however, the speculation of this possible drop was enough to cause a depreciation in the US dollar.
Even though currently the interest rate in the US is 5.25, economic indicators have changed expectations on possible future FED decisions. This is an example of how expectations/speculation can move FOREX (foreign exchange) markets.
Now that you understand how expectations can move the currency, let’s examine what specifically about these expectations make the domestic currency go up or down (appreciate or depreciate.)
Learning Why the Dollar or Euro Moves on Bank Announcements
This portion of the article will provide a brief overview to help you understand why, where, and how currencies move up or down. Knowing ‘why’ is crucial to understanding the basics of foreign exchange markets. Knowing ‘where‘ the currency will move will help you determine where to invest in forex markets. Knowing ‘how‘ will ensure you’re ready for future decisions and movements that affect the forex markets.
(This example will center around a pending interest rate announcement. There are a variety of factors that influence change in currency values but we’ll stick with this one.)
Let’s use the example from the beginning of this article.
The US labor numbers suggest a slowing of the economy. In a couple of weeks an announcement from the Federal Reserve (the central bank that controls monetary policy) is expected regarding the short-term interest rate. Let’s assume the Euro is constant for now and only the US dollar will be changing based on expectations.
As a result of the lower labor numbers expectations for a possible FED interest rate decrease has increased. The result even before an official interest rate announcement is a depreciation of the US dollar against the Euro.
Firstly, why did the dollar move? Well the possibility of a FED decrease in the short-term interest rate means future investments in the US will be worth less. The interest rate decreasing means less of a return for investors in a variety of money instruments (most short-term).
How does the dollar move? Well because there is a higher expectation that investments in the future will be worth less, less US dollars are demanded. Less demand suggests there will be a drop in the value of the US dollar (and with respect to the Euro, it will be worth more, hence the ‘depreciation’ of the US dollar.) We can also note that supply for the US dollar will increase as people liquidate their US dollar investments (be it currency or other money instruments) in favor of higher paying yields (like the Euro). This supply and demand as a result of the potential interest rate decline is one factor in the depreciation of the dollar.
Where will the dollar move? Well I’ve explained how an increase in the expectations of an interest rate drop will cause the dollar to depreciate (go down). So for example, in order to take advantage of the economic indicator announcement (in this case the labor figures) you would purchase Euro’s before it takes place. Of course, it may be the FED does not wish to decrease the interest rate.
Perhaps you have calculated (based on economic indicators or a big ‘hunch’ :P) that the interest rate will be unchanged the day before the FED announcement. You hold you dollars or buy some more. The day comes, there is no change, and all of a sudden people who thought it was going down want back into US dollars. The supply decreases as demand increases and your US dollar holdings have appreciated against all other currencies.
These types of transactions never close, are continuously going on, and measure in the billions. The FOREX market is the only market that remains open 24 hours a day and moves the most money. When we break down the movements in smaller steps we can actually begin to understand why, how, and where the domestic currencies will move. This is but one example of many, and of course, doesn’t consider the simultaneous movements and decisions for foreign currencies either!
Have fun with your investing, predicting, and foreign exchange tracking using our examples to help you understand a bit more about the nature of foreign exchange markets.
[tags]forex, forex us, us dollars, foreign exchange, foreign exchange markets, monetary supply, interest rates[/tags]